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There's No Need To Panic About Netflix's Debt

Worries about negative free cash flow are just a distraction from the real story here.

Sure, Netflix is putting up strong subscriber growth numbers, and it's the current leader in video streaming, the bears concede, but its current model is unsustainable, driven by debt and negative free cash flow. That combined with a high-flying valuation is a recipe for disaster, the bears claim. Rants about the company's cash burn are rampant on Twitter.

Hedge fund manager Doug Kass even said the company's valuation and lack of free cash flow makes him "airsick."

Image source: Netflix.

There is some truth to those cries of panic. Netflix has racked up $5 billion in debt, up from less than $1 billion in 2014, and the company is tracking for negative $2 billion to negative $2.5 billion in free cash flow this year. Management explains that strategy by saying that original content requires upfront spending, which then becomes amortized over time once it becomes an asset on the balance sheet. That's why the company is still posting operating profits even with free cash flow losses.

While there are risks in that strategy, the complaints about Netflix taking on debt seem misguided. After all, debt funding like this is standard practice among media companies, which borrow heavily to fund ongoing productions.

As the chart above shows, Netflix's direct media peers like Disney (NYSE:DIS), Twenty-First Century Fox (NASDAQ:FOX), and Time Warner (NYSE:TWX.DL) have around $20 billion in debt, while cable providers Charter Communications and Comcast (NASDAQ:CMCSA), which also owns NBC/Universal, have upwards of $63 billion in loans on their books. Naysayers may claim that those companies are free cash flow positive while Netflix isn't, but it's foolish to ignore the fact that Netflix is disrupting all five of these businesses. In investing, the future matters more than the present, and the future clearly favors Netflix with its fast-growing, streaming-only model. I'd be much more nervous about owning a company with a vulnerable business model and $63 billion in debt than I would be with Netflix.

The big picture

The red-lettered streamer just crushed its own guidance for the second quarter in a row, and the company's subscriber base is growing faster than ever before. Revenue growth, meanwhile, is surging more than it ever has in the streaming era, and should accelerate next year after prices go up.

The idea that Netflix's debt burden and negative free cash flow will somehow lead to the stock's unraveling comes out of an ignorance of management's control over spending. The company has promised to spend $7-8 billion on content next year, but that's a strategic choice, not a competitive necessity. Netflix is setting all the rules in the emerging streaming industry, and the company is willing to take on debt and go free cash flow negative to offer a content library that will fuel even faster growth. If it only spent, say, $6 billion on content next year, its financials would look better, but subscriber growth might slow, and the company is still focused on growth above all.

Netflix explains this strategy in its Long-Term View document, which says, "Our US contribution margin structure is set mostly top down. For any given future period, we estimate revenue, and decide what we want to spend, and how much margin we want in that period. Competitive pressures in bidding for content would lead us to have slightly less content than we would otherwise, rather than overspending."

In other words, Netflix isn't blindly spending money on content; it's carefully measured in accordance with the company's own revenue projections, and if programming gets more expensive then the service will simply have "slightly less content."

There are some legitimate questions about Netflix's debt strategy, such as why the company is borrowing money instead of making a secondary stock offering, which might make sense given the stock's lofty valuation. But it's a mistake to focus on the debt or free cash flow without taking into account the bigger picture. Streaming is a huge opportunity -- Netflix calls it once-in-a-generation -- and its content binges are helping it add subscribers and establish dominance while the market is ripe, before it matures and players become entrenched. The service is such a bargain that most subscribers are unlikely to leave once they join, which makes the model even stronger than it appears.

There may be a risk to Netflix's debt strategy, but it's not nearly as great as the bears seem to think. Based on the results over the last two quarters, management is doing exactly the right thing.

Jeremy Bowman owns shares of Netflix. The Motley Fool owns shares of and recommends Netflix and Walt Disney. The Motley Fool recommends Time Warner. The Motley Fool has a disclosure policy.

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